Barriers to Entry and Exit

This 'topic' and the next look at the four major market structures. Barriers to entry and exit is an important topic for all these market structures, but before we press on with a look at the barriers, it is worth briefly considering what the term 'market structure' means.

The topic of Market structure is about the structure of markets. In this 'topic' and the next, we shall be looking at the four main textbook market structures: Perfect competition, Monopoly, Oligopoly and Monopolistic competition. The reason why they differ is that they have different structures. By this I mean they have, for example, different numbers of buyers and sellers, different size firms and different levels of differentiation between goods, to name just three of the characteristics that determine the behaviour of any given market.

Probably the most important characteristic of a market is the extent to which the firms in that market can erect barriers to entry and barriers to exit to stop new competitors from entering the industry. The level of competition faced by a firm is probably the main determinant of its behaviour. I felt that the issue of 'barriers' deserved its own Learn-It.

Although this Learn-It is called 'Barriers to entry and exit', many of the barriers to exit are, by their very nature, barriers to entry as well. For example, it is difficult to leave an industry, even when making short run losses, if a lot of capital is tied up in the business. The knowledge of this fact before one considers setting up a business may be enough to put one off starting in the first place! The barrier to exit has become a barrier to entry.

With this in mind, the next section is called 'The barriers' rather than 'Barriers to entry', or 'Barriers to exit'.

Capital costs

As mentioned above, this can act as a barrier to exit as well as a barrier to entry. Quite simply, if you are struggling to get the funds together to start the business, then this is a 'barrier' to you entering the market. Even if you do have the capital, the worry that you will be stuck in an unprofitable situation with a lot of unrecoverable capital invested in the business may stop you entering the market in the first place. These 'unrecoverable' costs are often referred to as sunk costs. In most markets, if things go pear-shaped you can sell much of the equipment on to other firms in the industry. But costs like advertising are unrecoverable.

Obviously, the larger the industry you intend to enter, the bigger the capital (and sunk) costs and the bigger the barrier to entry (and exit).

Limit pricing

Existing firms may be operating a predatory pricing policy. As the title suggests, this is a policy designed to kill off competitors by reducing the price below cost price temporarily. The idea is that once the competitor is killed off, the firm can raise the price back up to the old level and steal all their customers. Limit pricing is similar to predatory pricing, except the firm in question is trying to 'limit' the entry of new firms by setting the price low enough to prevent new firms entering, but high enough to still make some sort of profit. Actions like this by incumbent firms obviously act as a barrier to entry for potential new firms.

Economies of scale

If existing firms are large, they are probably benefiting from economies of scale. This means that their average costs are lower by virtue of their size. Bulk buying economies is a good example. Potential firms are likely to start on a smaller scale and so will find themselves at an immediate cost disadvantage.

Patents

A patent is something that a firm may apply for if it has just invented a genuinely original product. If the patent is granted by the government, it gives the firm legal protection to produce the product without competition for a given time period (usually a number of years). After all, what is the point of spending time and money inventing something if everyone can copy you straight away? Patents create incentives for individuals to be innovative. Obviously this creates a barrier for firms wishing to join this new market.

There are other legal barriers imposed by the government. The Post Office, for example, is the only body that is allowed to offer postal services costing less than £1. Notice that there are loads of firms offering delivery services for larger packages (like DHL and FedEx), but nobody else offers 26p stamps for small letters.

Advertising and marketing

Established large firms tend to spend a fortune on advertising. Apart from the fact that they are trying to get you to buy the product in the short term, the long-term aim is to create brand loyalty. How many of you, when buying Coca-Cola from a newsagent, ask for a 'Coke' even if the only brand they sell is Pepsi? Does your mum do the vacuum cleaning or the hoovering? In both cases, the brand name is so entrenched that most people use the brand name as the generic name for the product. In the case of 'Hoover', the brand name has even turned into a verb! Having a strong brand image is very powerful for the firm in question and creates a huge barrier to entry for a potential new firm.

The strength of vertically integrated firms

Vertical integration is a form of merger. It is where one firm merges (or takes over) another in the same industry but at a different level of production. For example, a firm that manufactures cars could merge with a firm that produces car parts, or with a steel plant. This is known as backward vertical integration. If the car manufacturing firm merged with a group of car showrooms, this would be Forward vertical integration.

In the first case, the firm would now have control over some of the raw materials. In the second, it would have control over some of the retail outlets for cars. In both cases, the firm has become more powerful, making it harder for new firms to compete. The knowledge of this extra power would put off new firms from entering the car industry.

Experience economies

Although it is difficult to put figures on this, established firms are likely to have a cost advantage over new firms because they have more experience of the industry in question. An established restaurant will know when it will be busy and when it will be quiet. They are less likely to order too many materials or employ too many waiters on a given night. These are the sorts of things that can only be learnt with experience.